Financial Crisis, Great Recession, Productivity Puzzle Flashcards
Why do financial crises occur (investors lose confidence in assets, so demand collapses for those assets) (2)
B) why is it bad?
Fundamental reasons
Bubble-related reality check
B) because these financial crises can spillover into the real economy (Financial accelerator)
Why does the Wall Street Crash of 1929 & 2007/08 crisis warrant more scrutiny?
It was followed by a severe recession (i.e spillover to real economy), which doesn’t always happen after a crisis
Timeline of the 2007/08 GFC crisis
HSBC warns US housing not as strong as believed.
Run on the rock - bank run following Northern Rock receiving EFA.
Banking sector writedowns - banks forced to incorporate housing market related losses into reported profit figures. (Public realise true scale of problem)
- US gov acts as lender of last resort
- Fannie Mae rescue - US gov rescues giant mortgage lenders by taking them into ownership after they reveal huge losses
- Lehman Brothers goes bankrupt - US refuses bailout
- US gov rescues insurance giant AIG
- UK gov rescues RBS & Lloyds, assuming huge deficit.
Finally 2009 - huge budget deficit (10 years to recover budget)
What caused the GFC crisis (9)
Low interest rates (excessive risk taking)
Securitisation - converting illiquid assets into tradable securities to lend e.g CDS
Distorting compensation packages (short termism - bonuses based so go for short term gains)
Deregulation of financial services
Shadow banking e.g Hedgefunds - unregulated so take more risks
Failures of ratings agencies (AAA meaningless)
Sub-prime lending (lend to low credit score people)
Extreme leverage position of financial institutions
Collapse of housing and credit bubbles
How were they ignorant (4)
“This time it is different attitude” - following success of inflation targeting
Didn’t learn from East Asian crisis
Too much faith in regulators in developed countries
Financial Conduct Authority (FCA) - did not focus on stability of financial system
Areas where economic analysis is inadequate (3)
No satisfactory theory of bubbles and crashes (why they begin/end)
Banking in general equilibrium models
Models do not incorporate banking in a satisfactory way
What shows how financial crises can spillover to the real economy
B) How did the crisis spillover to real economy
Financial accelerator (financial markets impact real GDP)
B) Low interest, UK debt (borrowing) remained high, and many defaulted, so FI suffered losses.
So became more reluctant to lend: credit crunch and increase external finance premium. Slowdown of economic activity.
2008 recession
Where did send us back to in terms of GDP, and how long did it take to recover? And unemployment
6.1% fall in GDP - back to 2005 in terms of real GDP
Took 72 months to recover
Unemployment 5% to 8.4% - main concerns hysterisis, and REAL WAGE FALLING (EXPLAINED LATER)
So this 2008 recession ended the period of Great Moderation 1992-2008.
What was it
16 years of stability (low/stable inflation, strong growth, low and stable unemployment)
Known as NICE decade:
Non-inflationary continous expansion
How did The Great Moderation exist (5)
Structural change
Better macroeconomic policy
Central bank - (better monetary policy)
Good luck hypothesis - luck and policy combined
1st reason for great moderation:
Structural change - 2 characteristics
Modern supply chains - better adapted to shocks
Financial innovation - easier to access finance & smooth consumption
2nd reason for Great Moderation:
Better macroeconomic policy
Inflation targeting introduced - and successful (improved confidence and undertake investment)
Back to the 2008 recession: What was the main concern for large unemployment (around 5 to 8.4%)
What happened for those STILL employed too?
Hysteresis - greater increase in longer term unemployment - skills depreciate
B) Pay squeeze - real earnings fell (inflation rose but nominal wages keep up i.e not pricing themselves out, look FC 32)
III: Productivity puzzle
Productivity is important because a key source of growth and a country’s competitiveness.
How is productivity typically measured
Output per worker: Y/L
What is a better measure, and why?
Output per hour (since Y/L not all, people work full time)
Productivity trend overtime
Productivity slowdown - output per hour AND worker growth has been low
Around Great Recession 2008
What happens to productivity during recessions - use Y/L! (2)
How is their irony?
- output declines (Y falls so productivity falls)
- employment and labour hours decline (L falls, productivity increases)
So opposing effects on productivity, in a recession???
What does this imply
Productivity falls due to output falls, but should naturally return to its pre-recession upward trend since L falls
Since (un)employment lags output. (Brings productivity back up)
Barnett et al explains 3 reasons for puzzle (opposing forces on productivity)
1 EXTRA!
Measurement error
Cyclical factors
More persistent factors
And real wages!
1st reason for productivity puzzle:
Measurement error and Eval:
GDP (Y) or labour statistics (L) can be wrong
Eval: wouldn’t explain full extent of puzzle even if corrected
2nd reason for productivity puzzle:
Cyclical errors
Labour hoarding -
L doesn’t fall as much as perceived: Firms retain more workers than necessary in a recession since costly to reduce workforce and reexpand once over. (spare capacity since more supply than demand)
Evaluation of labour hoarding (2)
- Only likely during short recessions (for longer recessions costs of laying off is more tolerable)
- Employment actually increased while output fell during the 2nd phase of the UK prod puzzle.
3rd reasons for puzzle:
Persistent factors - lack of capital deepening (explain pre-crisis & post-crisis view)
B) What happened in the GFC
Pre crisis- credit easy to access so resources may go to non-productive projects.
Post crisis - credit crunch so ditch even worthwhile projects.
B)
During recession , firms expected to substitute labour for capital (capital deepening). Didn’t happen, firms maintained or even expanded labour input (as mentioned in last FC), since real wage fell!
So lack of capital deepening! Investment declined overtime from GR 2008 onwards)
Labour productivity expression in CD form
Y/L = A(K/L) to the 1-α
Using this expression, what does productivity depend on? And relationship
- Total Factor Productivity (A) positive rel
- Capital employed (K) positive rel
- Labour - negative rel
- Capital to labour ratio overall is important K/L. (Also RMB input prices r and w)c
Pessoa and Van Reenen’s view on productivity
Lack of capital deepening (shallowing) led to stagnant productivity puzzle. (Fall in K in previous CD expression)
What is a key determinant in the productivity puzzle
Real wages
Real wages in recessions
Typically, rigid, as output falls. However during the 2008/09 recession it did fall.
(Recall earlier we mentioned a pay squeeze)
Why did real wages fall
And what was the main negative
Workers did not price themselves out, as in previous recessions. Firms can maintain employment comparatively more than past recessions (explaining the lack of capital deepening!)
Main concern - lower productivity (higher L).
Why was labour cheaper though? Why did they not price themselves out? (3)
Fall in trade union power
More flexible contracts (firms weren’t fixed so gives them bargaining since lack workers lack job security)
High labour supply due to migration flows
MPL formula
MPL = α(Y/L)
How can we use MPL formula to create an adapted expression for productivity.
hint we have to make an assumption
Assume perfect comp (so MPL=real wage)
α(Y/L) = W/P
Then divide a to get
Y/L = 1/a (W/P)
Recessions prior 2008 one.
A) Draw a graph following a fall in output.
B) What would happen to productivity using our alternate productivity expression?
A) Output falls, so labour demand falls. Shift left.
We assume real wages are rigid (unlike 2008 where real wages fell) , thus unemployment created (labour supply>labour demand)
B) Productivity remains unchanged, since a fall in Y is matched by a fall in L
Evaluation of past recessions stylised approach
Too simple - ignores lagging indicator nature of employment. In reality we would get a brief fall in Y/L followed by a return to pre-recession level
(since employment lags behind output, so we will see short run effects of a fall in productivity following Y fall)
Now consider 2008/09 recession diagram pg 72
A) graph following a fall in output
B) Productivity using alternative expression
Real wages no longer rigid (because no longer priced themselves out due to the various reasons as mentioned e.g fall in trade union power)
So a fall in output will reduce labour demand, however since no longer rigid, no unemployment, since workers just accept the lower wage.
B) Fall in real wages (W) reduces productivity.
(using expression Y/L= 1/A (W/P))
In reality, are real wages flexible or rigid
Real wages unlikely to be either fully flexible or completely rigid, but inbetween.
What is the main determinant of material well-being( standard of living) in the long run?
B) how much £ has been lost per average worker following the lost wage growth
Productivity
B) £10,700 a year due to productivity slowdown causing real wage growth fall
Thatcher reforms to try “make Britain great again” (6)
Fiscal restructure (gov spending and tax) - underspent * tax reform badly designed
Privatisation
Competition strengthened
Pro EEC& EU single market
Industrial relations reformed
Innovation policy neglected
What went wrong? (5)
Tax - reform badly designed
Infrastructure - underspent
Education - quality slowly addressed
Land-use planning - not reformed
Inadequate innovation policy
Recommendations (3)
Increase pub/priv investment to address innovation policy to increase productivity (aim to increase public investment by 1% GDP annually, esp in key sectors e.g energy, housing, transport)
Promote efficient, resilient and inclusive economy (to address geographical inequality and opportunity)
Support knowledge sector, digitalisation and AI to drive efficiency
How did government respond to the 2008 recession in their fiscal policy and monetary policy
These will be outlined in the next few topics
Fiscal
- VAT cut temporarily
- Vehicle scrappage scheme & help to buy
- Fiscal targets
Monetary
- interest rate cuts (until lower bound)
- unconventional MP (QE, funding for lending, forward guidance
Keynesian approach: what do they focus on, who is involved, tool for intervention, and objective
Focuses on demand side - we have seen recession 2008.
Role for government - manage demand side e.g automatic stabilisers e.g unemployment benefits
Tool: Fiscal policy (tax and expenditure)
Objective: full employment
Neoclassical view on intervention (around 1970s where Keynesian deemed not fully practical)
What is role of government
Tool
Minimal intervention (crowding out+ricardian eq)
Monetarists - role of government is to manage expectations. Control inflation by inflation target to give confidence so agents can stimulate economy!
Tool - monetary policy (manage quantity of money to decide price level to thus control inflation/price stability!)
So Keynesian policy successful in 1960s, but not 1970 so neoclassical came. Was successful (shown by NICE)
But then GFC occured! (Remember minimum intervention i.e deregulation one of causes of GFC!)
So debate to which is the best! Both have failed
